Penalty Free 401k Funds During Divorce

With economic times being as tough as they are, many couples we see at Equitable Mediation Services of New Jersey cite money as the single largest obstacle to getting a divorce.  And while there are many benefits of mediation including significant cost savings of $20,000 or more in legal fees, if money is tight, as it is for many of us, there is an option some couples are using in order to get back on their feet more quickly.

Not that I am a big proponent of mortgaging one’s future, but there is a way to receive money from a 401k penalty-free when going through a divorce.  And while this option isn’t for everyone, it can be a good short-term bridge to get an individual a lump sum of money they can use to buy a house or pay down debt without having to pay the 10% early withdrawal penalty.  Keep in mind this option may not be for everyone, including those that are close to retirement.  I would recommend that someone who still has a fair amount of time to save for their retirement (10+ years) use this option and only as a last resort.  You should always speak to your accountant / attorney  / mediator to see if this is a good idea for you.

As part of your divorce, your attorney can draft what’s know as a QDRO – Qualified Domestic Relations Order.  This QDRO will outline the terms of the transaction and is filed along with your divorce and sent to your plan administrator.  A lump sum will then be given post-divorce from the plan administrator to the receiving spouse from the 401k of the other spouse.  By using the QDRO the receiving spouse would only have to pay the taxes on the money and not the 10% early withdrawal penalty. It is important to note, this can only be done for divorcing couples and not be used as a legal “end-around” to avoid paying early withdrawal penalties.

The amount transferred is completely dependent on the terms of your equitable distribution arrangements and can be used to either off-set the value of other assets divided during divorce mediation or in some cases, each spouse gives the other spouse an equal amount of money from their respective 401k’s to free up funds penalty-free with no net effect on the bottom line of their equitable distribution.  Your mediator can work with you to incorporate the terms of such an agreement into the Memorandum of Understanding and advise you on what questions to ask your attorney should you need further guidance.

As this is a rather complex financial matter, it is best that you contact us directly to discuss your specific situation so please give us a call at (908) 864-2177 if you have any questions about this topic or to schedule an initial meeting where we can review your specific situation and see if the transfer of penalty free 401k funds during divorce is an option for you and your spouse.